VISUAL PLANNED GIVING:
An Introduction to the Law and Taxation
of Charitable Gift Planning

14. Life Insurance in Charitable Planning, Part 1 of 4

Links to previous sections of book are found at the end of each section.

Planning with life insurance creates many potentially positive opportunities for donors, advisors, and charities. Yet, there can be bad outcomes from using life insurance as well. Some tax rules create negative consequences in certain cases. Some charities have had bad experiences and bad results working with life insurance professionals who promised more than they delivered. These potential pitfalls are no reason to ignore the benefits of life insurance, but rather should be a motivation to become more acquainted with the details of using life insurance in charitable planning in order to produce the best outcomes.

Many sophisticated charitable planning techniques such as Charitable Gift Annuities, Charitable Remainder Trusts, Charitable Lead Trusts, gifts of remainder interests in homes or farms, or bequest gifts in wills or trusts, all directly impact estate planning, typically reducing the heirs’ inheritance. It is not surprising then that another common estate planning tool, life insurance, can frequently be useful as a means to replace some or all of the heirs’ inheritance lost due to charitable planning. Further, existing life insurance policies may have accumulated substantial value over time, making them a potential candidate as a charitable gift. Finally, some donors may desire to fund a large posthumous gift for charity by creating and making premium payments on a new charity-owned life insurance policy. Thus, charitable planning commonly employs life insurance in three different ways: wealth replacement, gifting existing policies, and creating new policies for charity. These three uses for life insurance involve dramatically different tax and planning issues. Consequently, each type of application will be reviewed separately.

Potentially the most powerful use of life insurance in charitable planning is as a “wealth replacement” for heirs or other non-charitable beneficiaries. Life insurance generates a pool of money (wealth) at the death of the insured. For younger families this wealth can be especially important as a way to replace the income (or services) lost by the unexpected death of a family member. In charitable planning, life insurance does not replace income, but instead replaces wealth. Charitable planning often involves the transfer of substantial assets (wealth) to charity either during life or at death. Life insurance provides a mechanism to replace all or part of the wealth gifted to charity. This alternate source of wealth benefits the heirs or beneficiaries who might otherwise have inherited the assets donated to charity. Importantly, life insurance can replace wealth in a tax-advantaged way after charitable planning has removed the wealth in a tax-advantaged way, resulting in the possibility of multiple layers of tax benefits.

The most powerful layer of tax benefits in these multi-layered charitable plans comes from the charitable instruments themselves. As reviewed in other chapters, charitable planning devices such as Charitable Gift Annuities, Charitable Remainder Trusts, or gifts of remainder interests in homes and farms can generate wonderful tax benefits in income, capital gain, estate, and generation skipping taxes. Despite these enormous tax benefits, advanced charitable planning techniques all have one thing in common; ultimately, they transfer assets to charity. Clearly, this means that such techniques should be limited to those who truly have charitable desires. Yet even among the charitable, these philanthropic desires are often not the only goal in a donor’s plan.

Donors must often balance their charitable desires in estate planning against the desire to benefit family members or other non-charitable beneficiaries. The donor’s desires to benefit his or her family may set the limit for any potential charitable estate gifts (or other charitable planning techniques that diminish the remaining estate such as Charitable Gift Annuities). Life insurance can help balance these competing desires in a way that can increase both the gift to charity and the inheritance for other beneficiaries.

Not only can life insurance provide an alternative or supplemental inheritance to substitute for part or all of the wealth transferred to charity, but also, with certain types of planning, it can provide an inheritance that is not subject to estate taxes. For estates subject to the 40% estate tax rate, the ability to receive tax-free inherited dollars is understandably attractive. Thus, the heirs may do well to trade a smaller amount of tax-free insurance in exchange for giving up a larger inheritance when the larger inheritance would have been taxable. Combining this with the tax advantages of charitable planning can create a win-win scenario where the donor is able to provide more for both charity and heirs through creative planning.

How is it possible for life insurance proceeds to avoid estate taxation? In simple terms, the estate tax applies to everything owned by the decedent at death except assets transferred to a spouse or a charity. Thus, proceeds from life insurance owned by the decedent will be subject to estate taxation. However, if the decedent does not own the life insurance, then it is not normally subject to estate taxes at the decedent’s death. This is true whether the life insurance is owned by another person, such as another family member, or by an artificially-created legal entity, such as an irrevocable trust. The exception to this rule is that if the decedent first owned the life insurance policy and then transferred it to another person (or legal entity), the policy will still be included in the decedent’s estate for three years after the transfer. However, if the other person (or legal entity) originally purchased the policy then this waiting period does not apply.

How would this work if another family member, such as a child of the insured, purchased the policy? The parent gives money to the child in order to allow the child to purchase a life insurance policy on the parent’s life. Because the parent has not transferred the life insurance policy to the child, but has instead simply given funds to allow the child to purchase the policy, the parent has never owned the life insurance policy. Since the parent has never owned the policy, it will not be included in the parent’s estate. (If the parent had owned the policy and then given it to the child, the policy would still be in the parent’s estate for three years after the date of transfer.) Upon the parent’s death, the life insurance policy then pays its death benefit to the child. The child receives these life insurance proceeds free from estate taxation, because the life insurance policy was never in the parent’s estate.

The same concept applies if the policy is owned, not by a child, but by a separate tax-paying legal entity not controlled by the parent, such as an irrevocable trust. Trusts designed for this purpose are referred to as ILITs (Irrevocable Life Insurance Trusts). The ILIT is, for tax purposes, a separate person. Thus, when the parent dies, the life insurance policy and its death benefit are not included in the parent’s estate because another “person,” the ILIT, owns the policy. The ILIT then receives the policy proceeds and distributes them to the child (or to whomever the ILIT document names as beneficiary).

An ILIT allows for distribution to multiple beneficiaries and ensures that money given for premium payments will be used for premium payments. By using an ILIT, the parent can establish rules for precisely where and how the money will be distributed. Because the child does not own the ILIT, the child’s creditors, lawsuits, or divorce often cannot reach the ILIT assets. Although the parent cannot continue to directly control the ILIT after its creation, the parent can establish all rules that the ILIT trustee must follow in purchasing, paying for, and distributing the proceeds from the life insurance policy. This high level of control, without risk from potentially interfering family conflicts, is often attractive to those planning their estates.

The ILIT is not, by itself, a charitable planning technique. Instead, the ILIT often serves as an attractive addition to charitable planning. The immediate tax deductions and lifetime income typically generated by Charitable Gift Annuities and Charitable Remainder Trusts provide a natural source of funding for this type of life insurance planning. At the same time, these gifts also reduce the remaining estate for heirs, increasing the potential interest in using life insurance as a means of replacing this donated wealth. Other charitable planning techniques, such a gifting a remainder interest in a home or farmland while retaining the life estate, do not generate ongoing income, but do generate an immediate tax deduction. In this case, the donor may consider using the money saved from the reduced tax liability to purchase life insurance.

Although the Charitable Remainder Trust, Charitable Gift Annuity, or gift of a remainder interest in a home or farmland reduces donor assets, the heirs may prefer to receive proceeds from an ILIT owned life insurance policy. The estate tax may have cut the value of other assets by up to 40%. The ILIT-owned life insurance policy generates a tax-free death benefit. In this way, the donor gives the taxable inheritance to charity and replaces it with a non-taxable inheritance funded by the increased income and tax benefits generated through the planned charitable gift.

Combining charitable planning with life insurance planning can generate a range of tax benefits. The value of these benefits depends upon the tax circumstances of the donor. To see the potential power of these strategies, consider the case of a donor with a highly appreciated asset who is at the top federal tax rates for capital gains, income, and estate taxes. The donor has a $1,000,000 non-income producing zero-basis asset that she would like to sell, reinvest, and spend the interest income of 5% per year. (Low basis assets are a common financial planning challenge, especially with family businesses that started without a large initial cash investment.) She would like to leave the principal for heirs, but also has charitable interests. How can charitable planning make a charitable gift more affordable?

The traditional approach to the client’s goals would be to sell the non-income producing asset, invest it, spend the interest earned, and leave the principal to the donor’s heirs. This results in no charitable gift and substantial taxation. First, the sale of the appreciated asset generates a $238,000 federal capital gain tax (including ACA tax). Instead of having $1,000,000 to invest, only $762,000 remains after the taxes are paid. Earning 5% per year on this remaining amount generates $38,100 each year for the client to spend. The heirs inherit the entire principal, but due to a 40% estate tax on the principal, the heirs receive only $457,000 of the $762,000 principal.

As an alternative, the client could transfer the $1,000,000 asset to a Charitable Remainder Unitrust paying her 5% of the trust assets for the remainder of her life. In this case, the Charitable Remainder Trust sells the $1,000,000 asset. As a non-profit entity, the trust pays no capital gains tax. This leaves the entire $1,000,000 available to generate income for the client. The payments from the trust, earning 5% annually, will be $50,000 per year as compared with $38,100 in the non-charitable approach. In addition to the higher payments, the transfer to the Charitable Remainder Trust generates a tax deduction. The exact amount of the deduction will depend upon the prevailing interest rates and age of the donor, but suppose the deduction is 30% of the transfer, i.e., $300,000. This $300,000 deduction can lower the donor’s federal income taxes by $118,000.

Although the donor receives a large income tax deduction and greater income than with the first plan, the donor has partially disinherited her children who now have no claim on the asset. This is great for the charity which will receive the $1,000,000 at the donor’s death, but not as attractive for the heirs. To address this problem, the donor could purchase insurance using the value of the tax deduction and all or part of the increase in income. Although the amount of life insurance this will purchase depends upon prevailing interest rates and the donor’s age and health, it is possible that an $118,000 initial premium plus an annual premium of $11,900 would purchase a $457,000 life insurance policy. (Note that as interest rates rise, the charitable deduction may decrease, but the cost of the insurance also decreases.) Because an ILIT owns the life insurance policy, the heirs receive the $457,000 tax free. This is identical to the after-tax benefit received from the $1,000,000 asset, which, after paying for capital gains taxes and estate taxes, left only $457,000 for the heirs. In other words, in the charitable planning scenario, the charity receives a $1,000,000 gift without any net cost to the donor or the donor’s heirs. Of course, this is an extreme scenario in that the donor has a highly appreciated zero-basis asset and faces the highest federal tax rates. However, the charitable scenario actually becomes even more attractive if the donor lives in a state that charges taxes on capital gains in addition to the federal taxes on capital gain. Nevertheless, this example shows the potential power of combining charitable planning with life insurance planning as a way to benefit all parties.

Life insurance can also be used in less complex transactions. As an example, suppose a potential donor owns $100,000 of farmland that he would like to use for the rest of his life. At his death, he would like to leave the property to his favorite charity, but he is concerned about reducing his heirs’ inheritance too much. How might charitable planning help in this situation?

Pairing life insurance with income-producing charitable planning vehicles like Charitable Remainder Trusts or Charitable Gift Annuities is a common combination, because these gifts generate income that can be used to pay premiums. However, life insurance can also be combined with other charitable planning techniques that produce valuable tax deductions. For example, gifts of remainder interests in homes or farmland generate charitable income tax deductions but require no cash. The value of these deductions can be used to purchase insurance to help offset the heirs’ loss of the inheritance of the home or farmland. If estate taxes are a concern, the donor is able to use the value of the tax deduction from the IRS to purchase a tax-free inheritance (using an ILIT) for heirs in partial replacement of the taxable inheritance donated to a charity.

By giving the remainder interest in his farmland to charity, the donor generates an immediate income tax deduction. If the donor was age 55 and the §7520 rate was 2.0%, this gift would create an immediate deduction of $61,635. Assuming the donor could use this deduction at the top federal tax rate and a 5% state tax rate (fully deductible), it would lower his tax bill by $26,268.84. Depending on the donor’s health, this amount might purchase a $50,000 single premium life insurance policy. Other donors would be in different situations, but many would be roughly similar. If the §7520 rate was higher, the deduction would be lower, but the cost of life insurance would also be lower. If the donor were older, the deduction would be greater, but so would the cost of life insurance. With charitable planning, the donor is able to make the gift to charity, but also provide a substantial inheritance to his heirs. Here, the tax benefits from charitable planning fund the entire replacement inheritance. Of course, if the estate would be subject to estate taxes and the donor purchased the life insurance through an ILIT, the heirs are that much better off. The same transaction could be structured without life insurance. A donor could transfer the value of the tax deduction as a gift to an irrevocable trust for the benefit of the heirs (still using “Crummey” powers if necessary for estate tax planning). Through investment of these funds, $50,000 or more would be available for heirs if the donor lived to his life expectancy. The primary advantage of life insurance is that it removes the risk of an unexpectedly early death, guaranteeing the larger amount. Along with this, however, it also removes the potential benefit of an unexpectedly long life where the asset could have grown in value for several more years.

Ultimately, charitable planning can generate income and tax benefits that would not otherwise be available. The ILIT provides a mechanism to convert these additional income and tax benefits into estate tax-free wealth for heirs. The use of the benefits in this way can help to balance a donor’s competing desires for charitable and family estate transfers.

No gift or estate taxes result from the typical Charitable Remainder Trust arrangement. The donor receives an income for life and then at death any amount remaining in the trust goes to charity. Although the assets in the trust are included in the donor’s estate, they generate no taxation because these assets go to charity. However, there are other Charitable Remainder Trust arrangements that can have different tax consequences.

A donor may also establish a Charitable Remainder Trust that makes payments not only for the donor’s life, but also for the life of the donor’s spouse. This is a common arrangement for Charitable Remainder Trusts. It generates no estate taxation because all interests go to the charity and the spouse, both of which are non-taxable recipients due to the unlimited marital and charitable estate tax deductions.

In contrast to the previous examples, if the donor chooses to make his children (or any other non-spouse) beneficiaries of the trust this arrangement will generate estate taxation. At the donor’s death, the estate must pay taxes on the present value of the children’s annuity or unitrust interest. As before, the Charitable Remainder Trust assets are included in the donor’s estate. However, in this case not all of those assets are going towards marital or charitable gifts. The children inherit this benefit and, consequently, it is subject to estate taxation.

Because of the estate tax results from simply naming the children as secondary beneficiaries of the Charitable Remainder Trust, it may make sense to consider using an ILIT to accomplish the same purposes. In this case, the Charitable Remainder Trust provides no payments to the children. Instead, the ILIT purchases life insurance on the donor’s life and then receives the death benefit at the donor’s death. The ILIT then purchases annuities for the children that pay income to them for their lives. The net result to the children is the same – receipt of lifetime income. However, in the ILIT arrangement the value of the income interest is not subject to estate taxation.

By removing the children as secondary beneficiaries of the Charitable Remainder Trust, the payments to the donor can substantially increase without altering either the tax deduction or the ultimate charitable gift. The amount of this increase in payments can pay premiums on ILIT-owned life insurance throughout the donor’s life. The primary motivation for this substitution is to reduce estate taxes. However, if the donor’s estate is not subject to estate taxation, then this substitution may be undesirable because the increased income during the donor’s life will likely be subject to taxation (depending upon the tax characteristics of the underlying assets in the Charitable Remainder Trust). Donors should weigh the trade-off between income taxation and estate taxation in each case to find the most advantageous approach.